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Solvency and liquidity

Solvency and liquidity. Two closely related financial terms, dealing with a company’s ability to pay one’s debts, in the short or in the long term. To understand solvency, we must first understand its opposite: insolvency. To understand liquidity, we must first understand its opposite: illiquidity. Simply put: to be broke, or not to be broke, that is the question! ⏱️TIMESTAMPS⏱️ 00:00 Introduction to solvency and liquidity 00:42 Meaning of solvency and liquidity 02:30 Solvency and liquidity case study: JC Penney 11:02 Insolvency example: JC Penney 12:54 Liquidating a bankrupt company 13:36 Restructuring a bankrupt company The solvency, insolvency, liquidity, illiquidity discussion all revolves around the accounting equation: assets equal liabilities plus equity. Here’s a useful metaphor to understand how the terms relate. The glass on the left containing clear water represents assets. The glass on the right with the red liquid represents liabilities. Assets are bigger than liabilities. If we pour out the same amount of liquid from both glasses, bringing liabilities to zero, we still have enough assets left. This situation we call solvency. In the second situation, the assets are once again bigger than the liabilities, but the nature of the assets is different. The water, representing the assets, is frozen. If we had to pour out the same amount of liquid from both glasses, trying to bring liabilities to zero, we would currently fail, as the assets are not liquid. This situation is called lack of liquidity, or illiquidity. We need to get the water to melt. In finance terms, liquid assets are things like cash, receivables and inventory. Non-liquid assets are property, plant and equipment, goodwill and other intangible assets. In essence, there is solvency (possession of assets in excess of liabilities), but no liquidity. In the third situation, the assets are smaller than the liabilities. If we pour out the same amount of liquid from both glasses, trying to bring liabilities to zero, we’d run out of assets first. This is insolvency: being unable to pay the money owed on time. At this point, whether or not the assets are liquid or not doesn’t matter all that much anymore. To illustrate solvency and liquidity in the corporate world, we’ll take a look at the story of JC Penney, an American department store chain. When the company filed for bankruptcy reorganization in May 2020, some headlines suggested that “the pandemic claims another retailer”. In my view, the company had been very fragile for a long time, and the pandemic pushed it over the edge. Even without the pandemic, I am not sure the company would have survived. JC Penney is an interesting case study in terms of corporate strategy, and retail management. Penney has been struggling for a long time to remain relevant in an era when Americans are buying more online or from discounters. In this discussion, we’ll focus on the financial outcomes of the company’s strategy and operations. Zooming out from this specific case study, it’s important to ask the question “Insolvency…. now what?”. More specifically: to liquidate, or to restructure… that is the question! Let’s walk through a simplified example of both. Let’s say a hypothetical company has assets of $8 billion, liabilities of $9 billion, and negative equity of $1 billion, in other words it is insolvent with a negative net worth. The “old” shareholders have already lost their investment, their shares become void. Liquidation means selling off the assets, probably for less than their book value. The creditors have to write off part of their claim on the company’s assets as a result. You can then use the $6 billion in cash you generated from liquidating the assets to pay off $6 billion of liabilities. Alternatively, you could walk the path of restructuring. Same starting situation: a hypothetical company has assets of $8 billion, liabilities of $9 billion, negative equity of $1 billion, insolvent with a negative net worth. Write down part of the liabilities, and issue equity to the creditors. The reorganized company could continue operations with a recapitalized balance sheet. To understand #solvency, we must first understand its opposite: insolvency. To understand #liquidity, we must first understand its opposite: illiquidity. Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!